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Executives

Jay Worley - VP, Communications and IR

Peter McCausland - Chairman and CEO

Robert M. McLaughlin - Sr. VP and CFO

Analysts

Amy Zhang - Goldman Sachs

Laurence Alexander - Jefferies & Co.

Kevin Mccarthy - Banc Of America Securities

David Manthey - Robert W. Baird

David Begleiter - Deutsche Bank

John Roberts - Buckingham Research Group

Steve Byrne - Merrill Lynch

Mark Gulley - Soleil Securities

Edward Yang - Oppenheimer

Michael Harrison - First Analysis

Holden Lewis - BB&T Capital Markets

Airgas, Inc. (ARG) Q1 FY08 Earnings Call July 24, 2008 11:00 AM ET

Operator

Good morning, and welcome to the Airgas First Quarter 2009 Earnings Conference Call. Today's call is being recorded at the request of Airgas. All participants will be in a listen-only mode until the question and answer session of the call. For opening remarks and introductions, I will now turn the call over to the Vice President of Communications and Investor Relations, Jay Worley. Please go ahead, sir.

Jay Worley - Vice President – Communications and Investor Relations

Good morning, and thank you for attending our first quarter earnings teleconference. Joining me today are Peter McCausland, Chairman and CEO, and Bob McLaughlin, Senior Vice President and CFO. Our earnings press release was made public last evening and is available on our website, as are the slides that accompany this teleconference. To follow along, please go to airgas.com, click on the Investors shortcut at the top of the screen, and then go to the Conference Calls and Webcasts page.

During the course of our presentation, we will make reference to certain non-GAAP financial measures. Please note, the reconciliations to the most comparable GAAP measures can be found in our earnings release, in the slide presentation, and on our website.

This teleconference will contain forward-looking statements based on current expectations regarding important risk factors, which are identified in the earnings release and in our slide presentation. Actual results may differ materially from these statements, so we ask that you please note our Safe Harbor language. We'll take questions after concluding our prepared remarks, and we plan to end the teleconference by noon, Eastern Time.

Now I'll turn the call over to Peter to begin our review.

Peter McCausland - Chairman and Chief Executive Officer

Thanks, Jay. Good morning, and thank you all for joining us. We are pleased to report record results for the first quarter of 2009. By focusing... by continuing to focus on our strategic growth initiatives, by maintaining discipline in our day-to-day operations, and by drawing from our expertise in integrating acquisitions, we produced strong sales and earnings growth in a moderating economic environment.

Turning now to the quarter's financial highlights, record earnings of $0.81 per diluted share was at the top end of our expected range. We generated strong free cash flow of $58 million, compared to only $28 million last year, as we continued to produce high-quality earnings.

In addition, we continue to be presented with great investment opportunities in our core gas business, and our capital spending increased 35% to $86 million for the quarter. Operating margin in the quarter was even with last year, in part due to dilution from the Linde Packaged Gas business that we acquired in July 2007. Also, the pace of rising cost pressures from power, fuel and steel prices accelerated this quarter, and we are addressing those challenges with appropriate pricing actions and supply chain programs.

Sales in the quarter increased 22% to $1.1 billion, with acquisitions contributing 15% of the quarter's sales growth. Total same-store sales grew 7%, with price up 4%, and volume up 3%. Gas and rent grew 7%, and hardgoods same-store sales grew 6%. For both gas and hardgoods, there was probably some benefit in the quarter from the timing of the Easter holiday, offset by some slow business conditions associated with the June floods in the Midwest. July sales seem to suggest the continuation of the current environment.

Looking across our geographies, results were relatively uniform among our distribution companies. The Pacific Northwest, the Mountain West, Mid South, and Southwest regions posted the strongest gains related to investments in energy and petrochemical industries, as well as metal fabrication.

Energy and infrastructure construction remain strong, as do our customers in the medical, research, environmental, and food and beverage segments. Our hardgoods same-store sales accelerated from the fourth quarter, partially driven by a hyperinflationary steel market. Filler metals, which account for almost 25% of our hardgoods business, are composed of virtually 100% steel and have therefore undergone extreme cost escalation this year. Thus, far, we have been able to keep up with these increases and maintain our margin.

Machine and equipment sales growth was up sequentially in the quarter, still on the trajectory of slight year-over-year growth that we have seen in the past few quarters. Rising material costs are likely to drive hardgoods prices higher in the coming months, and we expect to keep pace with those cost increases as they occur. Volume growth should continue to be positive. Rising fuel, power, and steel are also pressuring our gases and gas container costs, and we recently announced a gas and rental price increase effective August 1st.

Our pricing strategy has been designed to keep ahead of the cost curve, and the curve has steepened in recent months. Specifically, we experienced higher than expected power costs at many of our ASUs, due largely to buy-through on power of interruptible contracts, which are common in the industry. Our ammonia business was also impacted by two large cost increases, while we anticipated only one. Together, these factors cost us a couple of pennies in the quarter.

Rather than react hastily, we elected to address the issue with one well-designed price increase, so as to ensure effectiveness while minimizing distraction for our customers. Our strategic bulk… our strategic product categories of bulk, medical and specialty gases, carbon dioxide, and safety products make up about 40% of our revenue. They continued to outperform and drive growth, as many of these products grow faster than the overall economy, present significant cross-sell opportunities, or are focused on non-cyclical customer segments like medical, life sciences, environmental, food and beverage, which grow faster than the economy.

Total strategic products posted 10% organic growth for the quarter, coming off an 11% growth rate last year, and an 11% compound annual growth rate over the last three years. Bulk gas same-store sales were up 13% for the quarter, as we continued to capitalize on enhanced production capabilities and a strong sales force. Our ability to engineer solutions to customers' needs has been particularly effective in winning new bulk accounts.

Specialty gases grew 15% for the quarter, driven by demand from key customers in biotech, life sciences, research and environmental monitoring. This is an area where Airgas innovation has made a significant impact on the supply chain, as we have implemented production automation that improves quality and consistency, while simultaneously reducing lead time and expense. Our growth is further propelled by our ability to engineer solutions for specialty gas applications.

Medical gases moderated, with 6% growth for the quarter. While our hospital, doctor, dental and other segments continued to show strong growth, we experienced slowing related to home care providers and distributors due to uncertainty around Medicare bidding and the regulatory environment. However, Congress recently passed a reversal of some of these programs, delaying the implementation of some, and canceling others. This should remove some ambiguity from the home care outlook, which we hope will stabilize the industry, and return growth in this segment.

Rounding out the strategic products, CO2 and dry ice were up 9% for the quarter, and safety was up 8%.

Our Strategic Account business grew 14% for the quarter. Our national infrastructure, technical expertise, and broad product offering creates real value for customers with multiple locations and has enjoyed recent success with contractors who work multiple [ph] job sites.

Along with our Red-D-Arc Welderental business, our Construction division focuses on energy and infrastructure contractors. Both initiatives continue to post growth of 20% or more in our areas where Airgas is the clear market leader. Over two-thirds of our contractor business relates to energy and infrastructure construction, which still has a very favorable growth outlook.

Radnor private-label products also continue to outperform the market, posting more than 30% growth this quarter. Existing product lines continue to make strong contributions, as do product line expansions, and the addition of Radnor brands in the acquired Linde, Merriam-Graves and National Welders stores.

Airgas Specialty Products is a business unit with product line adjacencies that complement our Distribution business, and it continues to post same-store sales growth in excess of 20%, the largest product line, ammonia, suffered volatile cost increases and significant supply chain disruption, which depressed margins this quarter. We are implementing pricing actions and supply chain solutions to address these issues.

Our refrigerant business, the smaller component of Airgas Specialty Products, has had two strong quarters in a row. The refrigerant business has a seasonal dynamic during warmer weather, and our growing presence in the business enhanced our sales this year. One element of our refrigerants strategy is to be a leader in reclamation, as production of various refrigerants will be phased out over the coming years, and the need for reclamation services will grow. In addition, we want to be a leader in distribution, leveraging our footprint to reach refrigerant customers nationwide.

We were excited to announce in June that we have a definitive agreement to acquire the assets and operations of Refron, a leading national distributor of refrigerants that also provides technical services and reclamations. They generated $93 million of revenue in 2007, and will be integrated with our existing refrigerant business into a new company called Airgas Refrigerants.

We expect to close the transaction in the coming weeks, and we believe this combination will prove to be a powerful growth engine as the refrigerants business continues to develop. Our acquisition strategy continues to contribute strategic value in many ways, as you can see from the chart on slide 3.

While fiscal '08 was a great year, fiscal '09 is off to a strong start as well. We have already completed or announced more than $130 million of acquired annual revenues and our pipeline remains strong.

The integration of the Linde Packaged Gas business continues to progress. There is still some infrastructure work in progress and migration of business to appropriate channels, but most of the heavy lifting is behind us, and we look forward to realizing the value of this acquisition for years to come.

Our first acquisition in '09 was A&N Plant, a European based supplier of positioning and welding equipment for sale and rent. A&N operates in Europe, Asia and the Middle East, serving a diverse customer base in offshore and onshore oil and gas, petrochemical, power generation, environmental, industrial plant and steel fabrication industries. The company joined Airgas as a part of Red-D-Arc, and is an excellent addition as we expand into foreign markets.

We were also excited to expand our domestic offering for Construction customers by acquiring Oilind Safety this quarter. Oilind is the leading provider of rental safety equipment and safety services, and is a strong complement to our Construction strategy.

As we've mentioned before, we continue to evaluate international opportunities, although our primary focus remains on domestic core and product line acquisitions through fiscal 2009. While we focus on growth initiatives to build sales and gross profit, we remain on schedule for delivering our $10 million goal of run rate savings from operating efficiencies this year. UT's cylinder test savings are the largest component of savings to date, while distribution logistics initiatives are starting to take hold and produce meaningful results. Brake programs, fuel management programs and fill plant efficiencies are also making a difference.

Another step in our pursuit of operational excellence relates to our enterprise systems. As we conveyed at our analyst meeting last year, we obtained rights to modify and implement Linde's SAP system that they use in their U.S. bulk and packaged gas business. The system is a mature and stable platform that has an effective proprietary module for managing the cylinder side of our business, and the Linde team of experts who had developed and run the system became part of the Airgas team in the acquisition.

We ran the acquired business on this system from July through October last year, while we converted to our legacy system. We then engaged a team of Linde and Airgas associates to evaluate the SAP system and compare it with our current system. We believe the SAP system is the right choice for Airgas, offering better features, functionality and scalability. Consequently, we've decided to move forward with a multi-year phased implementation. We have reached a license agreement with SAP, and we are in the process of evaluating systems integration firms.

Once we select an integrator, our plan calls for at least 12 months of design and testing, followed by three to four years of phased implementation. Our decentralized operating structure, where our operating units share a common platform but different data sets, will allow us to convert one business unit at a time. The process will minimize business disruption and conversion risk while building conversion expertise.

We already have strong capabilities in system conversions due to our acquisition strategy, and we have performed multiple conversions from SAP to our existing system. So, we are favorably positioned to manage this transition with a minimal amount of disruption, while creating maximum long-term value.

Near-term operating costs of $0.03 to $0.05 per share are included in our fiscal '09 guidance. In the long-term, this is another step that will position us in our quest to be a world-class operation in all of our markets.

Finally, our 2008 Annual Report is now available on our website. The theme this year highlights our ability to make each one of our one million-plus customers feel like they are truly one in a million. This is also the central focus of our core strategy too, whereby we will sharpen our ability to execute on the blocking and tackling fundamentals of outstanding customer service.

I have never felt as good about our business as I do today. We have the right strategies, the right operating model, and most importantly, the right people to continue delivering exceptional results. We are seeing success in our market strategies, such as energy and infrastructure construction, biotech and life sciences and medical gases. We continue to engineer solutions for our customers’ meeting needs with technology and innovation, enhanced supply chain capabilities and our national footprint. Our sales and operations teams are the strongest they've ever been, and we will continue to gain strength, together in pursuit of outstanding customer service.

Bob will now give us the financial review of the quarter.

Robert M. McLaughlin - Senior Vice President and Chief Financial Officer

Thanks Peter, and good morning, everyone. We continued to execute well across the board, and delivered strong results for our first quarter. To review our consolidated results, we'll start with slide number four. As I go through these results, please note we have GAAP reconciliations for various metrics on slide seven through nine.

First quarter earnings per diluted share grew 29% to $0.81, compared to $0.63 in the prior year. Sales increased 22% to $1.1 billion, reflecting strong performance in our strategic product categories and with acquisitions contributing 15% of the growth. Same-store sales increased 7%, with gas and rent growing at 7%, and hardgoods at 6%. Overall, price contributed 4% and volume accounted for 3% of our same-store sales growth. Gas and rent represented about 59% of our sales mix, consistent with the prior year.

Gross margin was 51.8%, a decrease of 30 basis points from last year. As Peter mentioned earlier, the dip was primarily related to the pace of rising costs impacting our atmospheric gases and ammonia. We are addressing these with appropriate pricing actions and supply chain efficiencies. Operating expense, as a percent of sales, was 35%, an improvement of 10 basis points over the prior year, and 30 basis points sequentially.

Operating income for the quarter was $135 million, up 21% over last year. Operating margin was 12.1%, and essentially flat with both the prior year and sequentially. Our Distribution segment operating margins continued to expand, increasing 50 basis points over the prior year, but the consolidated margins were negatively impacted in the quarter by accelerating cost and sales mix shift in our ammonia business, as well as power cost escalations at our ASUs.

There were 85 million weighted average shares outstanding for the quarter, up about 1.5% from last year and flat sequentially. While we reinstated our share repurchase program in March this year, we did not buy back any shares during the first quarter. We currently have about 116 million of authorized spend available on our buyback program.

Our return on capital was 13.3%, 10 basis points below the prior year, and up 10 basis point sequentially. Due to the trailing 12-month nature of the calculation, the impact of the Linde Packaged Gas acquisition continues to be dilutive due to the impact of integration expense and the inclusion of their operating results for periods prior to achieving full targeted synergies. Subsequent to full integration and synergy attainment, the acquisition will contribute returns consistent with the base business, which is generating strong improvement in return on capital.

Our primary working capital metrics held consistent with recent trends, with DSO at 48 days, and inventory turns at 4.7. Free cash flow was $58 million, compared to $28 million last year, driven by strong growth in operating cash flows, and effective working capital management.

We have generated free cash flow at or above $58 million for the last four consecutive quarters, which reinforces the strong cash flow nature of our business, and the quality of our earnings. Adjusted debt at the end of the quarter was a little over 1.9 billion, and roughly flat with last year.

Our free cash flow was able to fully fund acquisition spending of $184 million over the past four quarters. Our adjusted debt-to-EBITDA ratio is now below 3, comfortably in the middle of our target range of 2.5 to 3.5.

We were encouraged by our successful bond offering in June, which priced $400 million of 7.125 [ph] senior subordinated notes at par. The notes are due in 2018 and help to extend and balance our debt maturities and enhance our liquidity.

The improvement in our credit profile was acknowledged by the rating agencies. S&P raised our rating to investment grade, at BBB minus, while maintaining our positive outlook. Moody's maintain their current ratings, and raised their outlook to positive.

Please turn to slide 5 and look at our segment results. Distribution sales were up 22% to $927 million for the quarter, with same-store sales growth at 6%. Distribution gas and rent was up 6% and hardgoods was up 6%, with price accounting for roughly two-thirds of the growth and volume, one-third.

Gas and rent represented approximately 54% of our Distribution segment sales mix, consistent with the prior year. Gross margin was 50.1%, an increase of 20 basis points over the prior year, as we have done an effective job at managing our cost and pricing discipline in this escalating cost environment.

Operating income in the Distribution segment was $113 million, up 26% over the prior year. The related operating margin improved 50 basis points to 12.2%, primarily driven by the leverage on strong organic sales growth and operating efficiencies.

Sales for All Other Operations increased 29%, with same-store sales up 13%, driven by strong growth in refrigerants and ammonia sales, as well as CO2 and dry ice. Operating income was roughly flat for the quarter. Operating margin declined by 260 basis points, driven primarily by the rapid cost escalations in the ammonia business, and power escalations in our ASUs. As previously mentioned, we are addressing these challenges with appropriate pricing actions and supply chain efficiencies. Sequentially, operating margins are up 110 basis points, as seasonal CO2 and dry ice sales accelerated from the fourth quarter.

Please turn to slide six, capital expenditures. Year-to-date capital spending was $86 million versus $63 million last year. As a percentage of total sales, capital spending increased by 70 basis points driven by major planned projects, such as ASUs, CO2 plants and post acquisition spending. These types of expenditures are reported in the other category of our capital. Excluding the other category, capital expending [ph] as a percent of sales dropped 70 basis points from 4.4% last year to 3.7% this year.

Capital expenditures related to our SAP project are estimated to be in the range of $55 million to $60 million, of which approximately $20 million will be spent this fiscal year. The two ASUs that we have under construction are progressing according to plan, with the Indiana plant scheduled to be on-line by January 2009, and the Kentucky plant on-line by April 2009. Plans to load both plants are ahead of schedule.

For the second quarter, we expect to earn between $0.82 and $0.84, representing a 22% to 25% increase over the prior year, excluding the $0.03 National Welders charge, and $0.04 of acquisition integration costs, both incurred in the prior year.

We are increasing our full year guidance to $3.30 to $3.40 per diluted share, including an estimated $0.03 to $0.05 of expense associated with the SAP project that Peter outlined earlier. Our previous guidance did not incorporate these incremental SAP costs.

We have assumed the continuation of the current U.S. economic environment in our guidance, with virtually no recovery in the latter part of the year. I'll now turn it back to Jay to begin the Q&A portion of the call.

Jay Worley - Vice President – Communications and Investor Relations

That concludes our prepared remarks. As we begin the Q&A portion of the call, we ask that you limit yourself to two questions and one follow-up, and then get back in the queue if you have further enquiries. The operator will now give instructions for asking questions.

Question and Answer

Operator

Thank you, Mr. Worley. [Operator Instructions]. And our first question comes from Bob Koort with Goldman Sachs.

Amy Zhang - Goldman Sachs

Good morning. This is Amy Zhang sitting in for Bob. Thanks for taking my questions. My first question is related to the same-store sales growth trends for gas and rent versus the hardgoods. Compared to last quarter, the same store sales growth for your gas and rent looks [inaudible] but the hardgoods look [inaudible], so I was wondering, going forward, do you expect the similar trend into the next quarter?

Peter McCausland - Chairman and Chief Executive Officer

Right now, we're seeing a continuation of the same, and we're assuming that our sales will sort of be in the mid-single digit ranges for the rest of the year.

Amy Zhang - Goldman Sachs

Okay, and then... I think PDI was essentially talking about a continuing softness with their hardgoods business. Can you just give us a little bit color why your hardgoods has outperformed your competitor?

Peter McCausland - Chairman and Chief Executive Officer

Not really. I don't know what's driving their business, I think we're doing well because we have the broadest product service offering in the business, and the infrastructure to support it, on both the gas and the hardgoods side. And a lot of customers are deciding to give their business to Airgas, and we are thankful for in this moderating economic environment.

Robert M. McLaughlin - Senior Vice President and Chief Financial Officer

We certainly are also getting a lot of benefit from our safety products, which is part of our strategic product category, and we continue to see and are optimistic about our cross-sell opportunity with that product line.

Amy Zhang - Goldman Sachs

And my final question is, what's the magnitude of the cost inflation during the quarter, because it looks like you're pricing of gas a little bit behind, because of the escalation, do you expect additional pricing actions to outpace the cost increase when we're heading to the second quarter?

Peter McCausland - Chairman and Chief Executive Officer

Well, the answer to... yes, we expect our pricing actions will put us ahead of the curve again. The two areas where we had cost inflation that we didn't fully pass-through were in our ASUs, and in our ammonia business.

And the ammonia business, that's simple, ammonia is a volatile agricultural commodity and we expected one price increase, we got two. So, that's a more volatile business in our Distribution group, so we're going to... you will find situations where we are a quarter behind there, or a quarter ahead. It's harder to do that... predict there.

At the ASUs, we had to buy through power, just like every other industrial gas producer in the United States. But most of our ASU output is sold through our regional companies. And the bulk customers are customers of the regional companies. And those customers buy a lot of other things from us too, in many cases. So rather than hassle the customers with an immediate price increase on the bulk, we decided to wait until we were able to make a comprehensive price increase covering all of our products, which we announced, and which will be effective August 1. And yes, we intend to be ahead of the cost curve again, as we implement that price increase.

Amy Zhang - Goldman Sachs

Okay, thank you.

Peter McCausland - Chairman and Chief Executive Officer

Sure.

Operator

And next will go to Laurence Alexander with Jefferies & Co.

Laurence Alexander - Jefferies & Co.

Good morning.

Peter McCausland - Chairman and Chief Executive Officer

Good morning.

Laurence Alexander - Jefferies & Co.

First, just a few. small details, with the cost headwinds in the All Other segment, can you break out roughly how much of a headwind was tied to the ammonia versus the ASUs, was it roughly equal or --?

Peter McCausland - Chairman and Chief Executive Officer

It was equal.

Laurence Alexander - Jefferies & Co.

Okay.

Robert M. McLaughlin - Senior Vice President and Chief Financial Officer

Just about equal.

Laurence Alexander - Jefferies & Co.

And then, when you... how much... with the acquisitions you've done so far this year, how much of a integration expense drag do you expect in the balance of the year that is embedded in your outlook?

Robert M. McLaughlin - Senior Vice President and Chief Financial Officer

Nothing significant from the acquisitions that we've done today, Laurence.

Laurence Alexander - Jefferies & Co.

Okay. Perfect. And can you just give us an update on the M&A pipeline, both in the US, and outside the US, and also, tried to... on the process chemical side?

Peter McCausland - Chairman and Chief Executive Officer

Yes. Well, I would say that our pipeline is full, most of the opportunities represent core business acquisition opportunities right here in the US, or adjacencies like in process chemicals, and then we're exploring a number of overseas opportunities, but as I said, I think the vast majority of our acquisitions over at least this year will be domestic. And it's hard to predict when you will make acquisitions, but I can say that we are off to a good start this year, and the pipeline is full, and we're optimistic that we're going to probably exceed the guidance that we had given of $150 million acquired sales guidance that we give every year.

Laurence Alexander - Jefferies & Co.

Perfect. Thank you.

Peter McCausland - Chairman and Chief Executive Officer

Sure.

Operator

And our next question today will come from Kevin McCarthy with Banc of America Securities.

Kevin Mccarthy - Banc Of America Securities

Yes. Good morning. I was wondering if you could advise the volume and price split in your hardgoods business, please?

Robert M. McLaughlin - Senior Vice President and Chief Financial Officer

It was roughly two-thirds price, and one-third volume.

Kevin Mccarthy - Banc Of America Securities

Okay. And if you look at some of the product lines within hardgoods that you would consider leading indicators, maybe larger ticket welding equipment or on the consumable side, welding wire. What are you seeing in June and the order book for July in terms of trends there?

Peter McCausland - Chairman and Chief Executive Officer

Well, sequentially our equipment business, which is a capital item and usually it foreshadows an increase in activity, it actually improved. We're also seeing lots of... which is unusual, you know, given the economic environment, everybody's seeing doom and gloom. We're also seeing a lot of interest in automation, and I think that's driven by a number of things: One is, it's hard to get skilled labor and number two, people want to take the labor element out of production. Number three, automation has improved, but number four, I think it also reflects optimism on behalf of our metal fab customers that yeah, this is a slowing economy but overall, the metal fab business is faring relatively well, and we find that a lot of our customers are pretty optimistic.

Kevin Mccarthy - Banc Of America Securities

Okay. And then finally, Peter, in the wake of the Refron deal, do you see other acquisition opportunities in refrigerants, and maybe you could elaborate a little bit on the long-term strategy and long-term opportunity, given the need for recycling, etcetera?

Peter McCausland - Chairman and Chief Executive Officer

Well, we do see other opportunities in refrigerants. They tend to be... most of them would be smaller distribution-type companies and regions, but there are a couple of other interesting opportunities, not just domestically. There's also opportunities in other parts of the world. Refrigerants are going to be with us for a very, very long time. They're the kind of very... many, many of our industrial customers use refrigerants, industrial and commercial customers use refrigerants. It's a household product. They want a reliable, reputable company handling them. There is an environmental play here, because reclamation of refrigerants is taking hold, and it's going to be a big business. And we have the reclamation capabilities and we intend to be a big player in it.

So, and returnable containers may very well become... they should... we should have returnable containers in this business. Whether we'll end up having them or not is another question, for the smaller ones. They are returnable for the larger ones. So, we think it's a great adjacency for us, we think it can become a rather large business, and we think it can be an international business, as well as a domestic business. So, we're pretty excited about it.

Kevin Mccarthy - Banc Of America Securities

Great. Thank you very much.

Peter McCausland - Chairman and Chief Executive Officer

Sure.

Operator

And our next question comes from David Manthey with Robert W. Baird.

David Manthey - Robert W. Baird

Hi, good morning.

Peter McCausland - Chairman and Chief Executive Officer

Good morning.

David Manthey - Robert W. Baird

I was wondering if you could talk about, in the press release you mentioned a moderating economic environment, that may just be a general question, but Peter, you've already addressed a couple of the areas where you're seeing strength, could you talk about any geographies or market verticals where you're seeing softening over the last quarter?

Peter McCausland - Chairman and Chief Executive Officer

Well, it's very hard to get a read on it, to tell you the truth. I read one regional company, and they say that metal fabrication is very strong, and then you go to another regional company, and they say that small and medium metal fab customers are slowing down. But the large ones that... customers that manufacture equipment for export or for infrastructure projects are still strong.

And then you go and... there's five new auto plants going into the United States, all foreign producers, there's a new railcar plant coming in, several new steel plants and things like that. So, it's very, very hard to get a read on it, what's going on. But when I say moderating, I'm saying we are coming off double-digit sales growth over the last few years. So, when you're only at 7% it's moderating, and I read the papers like everyone else, and read about the credit crunch and residential construction... by the way which we have nothing to do with practically... and there is a disconnect between Wall Street and Main Street, Main Street is not that bad, but it's slower than it was two years ago.

David Manthey - Robert W. Baird

Got it. Okay, thanks. And then the second, is it my understanding that the Distribution segment bore the burden of the electricity price increases at the ASUs. And then, as we look to the new price increases here, August 1st, do these not only recapture cost increases from other suppliers, but also would help alleviate transfer pricing, and then help margins back in your Other Operations segment?

Peter McCausland - Chairman and Chief Executive Officer

Exactly. We... the regional companies are big buyers of product from our ASUs. They buy most of the product, most of the output, I think it's like high 80s percent. So, it's all in-house. We are raising our transfer prices to our distribution companies, and at the same time, that the distribution companies are going to the market and getting price increases, and so, this is a comprehensive price increase designed to get us ahead of the curve. I think we've done a good job of this in recent years, and I'm expecting good results here.

David Manthey - Robert W. Baird

Great, thank you.

Peter McCausland - Chairman and Chief Executive Officer

Sure.

Operator

And next we’ll go to David Begleiter with Deutsche Bank.

David Begleiter - Deutsche Bank

Thank you, good morning. Peter, just on this August 1st price increase, how much, if any, resistance are you meeting, and what portion of your overall business do these price increases impact?

Peter McCausland - Chairman and Chief Executive Officer

The price increases, in fact, impact most of our business. We're raising prices across the board in our Distribution business, and in our gas ops division. We are raising prices in ammonia, CO2, refrigerants, we are raising prices all over. The initial feedback has been good. Customers understand... I wrote a letter to the customers this year, a three-page letter and we put a lot of thought into it, we got a lot of input from our field people on this letter. And we explained in that letter that our three major inputs are electricity, which is about 70% of the cost of producing atmospheric gases and CO2; diesel fuel, because we run to Mars and back about three times a year; and steel, and because the containers that we use to store and transport gases are all made of steel and filler metals are almost 100% steel. And that those three commodities were in rapid inflationary escalation, and that we were under severe pressure and that we needed to pass through these costs.

But we also went on to explain in the letter what we were doing for our customers, and we explained the investments we are making in efficiency programs, in safety programs, emergency response, and things like that, so that the customer wasn't just... so we could explain to the customer that we were trying our best to keep prices as low as we possibly could.

And the response has been very good to the price increase, the letter and our people tend to execute pretty well. We... customers tend to understand, in a rising energy environment, that we need price increases. So, it's not over till it's over. You never know how well a price increase goes until a couple of months after. And there's always give-backs and things like that, and we're working hard to make sure that this is a very good price increase.

David Begleiter - Deutsche Bank

Understood, and just on the two new ASUs you mentioned it was going well, trying to fill them, when do you expect to have them filled, either before or after they begin operations?

Peter McCausland - Chairman and Chief Executive Officer

Well, the first one's going to be on-stream in December in New Carlisle, Indiana, and then the second one in Carrollton, Kentucky is April 2009. We have ramp-ups scheduled, we're ahead of both schedules and... but you mean, when will they be operating at 88% capacity, which is kind of max for a Distribution group... I mean, for an ASU? Pretty soon after they're built, because we buy huge amounts of gas from third parties, and we'll be able to maximize those loads almost immediately.

David Begleiter - Deutsche Bank

Thank you very much.

Operator

And our next question comes from John Roberts with Buckingham Research Group

John Roberts - Buckingham Research Group

Good morning.

Peter McCausland - Chairman and Chief Executive Officer

Good morning.

Robert M. McLaughlin - Senior Vice President and Chief Financial Officer

Good morning.

John Roberts - Buckingham Research Group

I wanted to compare the delayed price increase on the bulk customers with what you might do, say, if you didn't have a bulk relationship with some customers. So, for example, there are a lot of customers that buy bulk from Air Products, and you serve the packaged gas, based on the acquisition you did a few years ago. I assume they got immediate price increases on bulk from Air Products, and you've held back though on your bulk customers. Why not treat them the same as they're getting when they've got a mixed mode of service?

Peter McCausland - Chairman and Chief Executive Officer

Well, first of all, I don't know if your assumption is correct or not. I don't know... but I did note when I read the transcript of the Air Products call that they were a little behind the curve also in raising prices. But what they do in prices is their business. It's just that our gas air separation plants are in gas ops, and then there's a transfer pricing mechanism. So, we have a little bit of a disconnect there and we just felt like more... it was only like a penny. So, why disrupt a nation-wide multi-product pricing initiative involving a lot more than the one penny, or $1.3 million, whatever it was, and race to get the price increase. Our business is good. We knew we were going to have a good quarter, and that we were going to hit the high end of the estimates, and so we run the business for the business, and the numbers take care of themselves.

John Roberts - Buckingham Research Group

Okay. I didn't realize it was as small as you've just made it out to be.

Peter McCausland - Chairman and Chief Executive Officer

Yes.

John Roberts - Buckingham Research Group

Secondly, did you quantify...

Peter McCausland - Chairman and Chief Executive Officer

And it was mostly June, John.

John Roberts - Buckingham Research Group

Okay, did you quantify how much the new incremental SAP cost would be for the current fiscal year?

Robert M. McLaughlin - Senior Vice President and Chief Financial Officer

Yes. $0.03 to $0.05 is our estimate.

John Roberts - Buckingham Research Group

So you were saying, had you not made this decision during the quarter to go after SAP, you might've raised guidance by another $0.03 to $0.05?

Robert M. McLaughlin - Senior Vice President and Chief Financial Officer

Well, we effectively did.

John Roberts - Buckingham Research Group

Yes. Okay. Thank you.

Operator

And next we'll go to Steve Byrne with Merrill Lynch.

Steve Byrne - Merrill Lynch

Hi, thank you. Your mid-single digit forecast for same-store sales this year, does that apply to both gases and hardgoods?

Robert M. McLaughlin - Senior Vice President and Chief Financial Officer

Yes.

Steve Byrne - Merrill Lynch

And so if we look back seven years ago, when your... the last time IP contracted year-over-year, your hardgoods contracted sharply at that time, and obviously, you're not expecting that this year. Is that a reflection of maybe market share gains that you are also getting, in addition to the product mix that you talked about earlier?

Peter McCausland - Chairman and Chief Executive Officer

Well, part of it is pricing of steel. Part of it is... we also don't expect non-residential construction to do what happened... what it did seven years ago, when it fell negative at the same time IP fell negative. The outlook for our customers in infrastructure construction is very good, they have historically large backlogs. And we have a rising price environment versus a falling price environment, and we're a very different company and we didn't... we bought Air Products back then on the downside as we were moving into further recession, and its sales were falling pretty rapidly at the time. And so, there are a lot of reasons why we were more confident... we are confident that we won't have a repeat of that, subject to no severe deterioration in the environment from here. We're assuming, sort of, no improvement, but no severe deterioration either.

Steve Byrne - Merrill Lynch

Okay. And you reported some pretty robust sales growth in items like Radnor and safety products, and so forth, do you believe that you're gaining market share in some of those hardgoods products as well?

Peter McCausland - Chairman and Chief Executive Officer

Yes. We think we are gaining some market share, and we are also in the private-label area where we bought a lot of companies, Linde and Merriam-Graves, and then we merged National Welders into Airgas, and that's a lot of branches, a lot of distribution, hardgoods distribution business that we can convert to Radnor. And so part of it's driven by that and Radnor tends to be a lower priced solution for a lot of our customers, and that was actually one of the things that I highlighted in my letter that we were doing for our customers, having high-quality but lower priced solutions on the hardgoods side.

Steve Byrne - Merrill Lynch

And then just lastly on your pricing, what portion of your contracts would you say you are able to implement a fuel surcharge rapidly versus a more formal price increase, like you posted for August 1. Do you have that ability to push through fuel surcharges quickly?

Peter McCausland - Chairman and Chief Executive Officer

Yes. We do. First of all, we have fuel surcharges in place now and they go up and down with the price of diesel fuel, and as often as every two weeks, I think now. So, we weren't complaining about the diesel fuel prices impacting our earnings, because pretty much we're matching the revenue with the expense there. The... the thing that... where we were a little bit behind the curve was the electric power costs in our air separation plants, particularly in the month of June. So… and we're attacking that with a price increase.

Steve Byrne - Merrill Lynch

Okay, I got you. Thank you.

Peter McCausland - Chairman and Chief Executive Officer

Sure.

Operator

And our next question today comes from Mark Gulley with Soleil Securities.

Mark Gulley - Soleil Securities

Hi, good morning, guys. Two questions. Peter, at the risk of beating to death this lost Linde [ph] price increase and how it relates to other products sold to large customers, forgetting about the policy taken thus far, on a go-forward basis, would it be your intent to continue to link the two, or would you segregate the two, and more closely tie lost Linde price increases to costs, as the majors do?

Peter McCausland - Chairman and Chief Executive Officer

Yes. Well, it's a good question and those plants are in the gas ops segment, and they fill 90-some percent of their output to the Distribution segment. We are looking at segment analysis, and reporting, and seeing whether or not we're... we've got it properly aligned. But again, I think everybody is making too big of a thing here. This is $1.3 million, and it's going to be more than recouped through our pricing action, and we're going to get ahead of the curve. And I think that... going out once with a comprehensive price increase, where the salesman has to go and talk to the large customers about his bulk, about the cylinder gases, about the rent, and all at once is a much better situation in terms of effectiveness and is a better in terms of hassle factor for the customer.

Mark Gulley - Soleil Securities

Okay. Secondly, I want to explore the SAP conversion.

Peter McCausland - Chairman and Chief Executive Officer

Sure.

Mark Gulley - Soleil Securities

Investors sometimes are understandably nervous about companies that undergo these things, because oftentimes these benefits are delayed and the cost are greater than expected...

Peter McCausland - Chairman and Chief Executive Officer

Right.

Mark Gulley - Soleil Securities

So, can you kind of walk us through why investors may not have to be nervous about your conversion?

Peter McCausland - Chairman and Chief Executive Officer

Well, I'll comment first, and then I'll let Bob comment, because he probably has a different view. First of all, we have a very high... we have pretty high costs now, we maintain like 28 different data sets, and we're holding this system that was made for small companies together by all kinds of extraordinary efforts. We also have a different system that's running our distribution centers, and the interface with them is working, but it's not as good as it could be, if we were on one enterprise system. So number one, we're not going from a low cost to a high cost maintenance environment. In fact, we don't expect any significant increase in costs, maintenance costs of our system as a result of this.

Number two, we're really good at systems conversions. We do them all the time. We do them backwards and forwards and six ways to Sunday, because we're an acquisition company and we've got a great team and these people are just... they're animals. They're so dedicated and they get companies up and running over a weekend, and that's really something remarkable when you consider how data-intensive our business is, with an average invoice of less than $200. And so I think investors can take comfort from that.

Number three, we bought the SAP system when we bought the Linde Packaged Gas business. They had this... it was running, we continued to run it for a number of months. We got the SAP team at Linde, which is a really good bunch of people who had developed the software and implemented it at Linde. And then the next item I would say is we tested it, we put a team together of about 150 people, and we tested the upgraded version of SAP with the cylinder gas or the cylinder control module that Linde had and which is very good ,and it works perfectly.

So, we tested... the tests we ran were in our environment. The next point I would say is that other companies in the distribution space like Grainger and Graybar have implemented SAP with great results. Linde runs SAP, Air Products runs SAP, so we know it's good for the gas business. And we think we've got a very favorable arrangement with SAP and we hope we get a similar one with the integrator. So, no one was pushed back harder than I did on any kind of system change, but I'm convinced that the work that this team did and the recommendation they made are both good.

And I also would point out that the conversion process is going to be very easy because of the way we're organized with 28 different data sets. Every one of our regional companies... every one of our operating units has a CIO, okay? And we can just go one at a time, and the first one probably won't be really smooth, but we may take the old Linde Packaged Gas business, or the region companies that were... they've got most of that business, like Great Lakes. And we might take them first. Because they've all been on SAP and they know how to run it, and then we develop teams to go to the second one. And our implementation skills get better and better as we go, and there's no danger in… because we have all the translational programs, from SAP to CU and back again, and to our data warehouse. So, there's not... I think we've got it pretty well covered. I'm not really worried about it.

Mark Gulley - Soleil Securities

Thank you.

Operator

And our next question comes from Edward Yang with Oppenheimer.

Edward Yang - Oppenheimer

Hi, good morning

Peter McCausland - Chairman and Chief Executive Officer

Good morning

Edward Yang - Oppenheimer

Just following up on the earlier question about your hardgoods performance versus PDI, what's your exposure to Canada? I would think that Ontario manufacturing is fairly weak, and maybe some of your geographic exposure could account for the difference?

Peter McCausland - Chairman and Chief Executive Officer

Well, maybe, I don't know. We're in Canada... we're in Western Canada we're mostly gas, we have a medical business out there, and we do have a ... our core business out there, which is sort of half gas, half hardgoods, but it's not that big. So, Canada didn't really have a major impact on our hardgoods performance.

I don't know what kind of impact it has on Prax's performance in Canada. But Canada's hardgoods, I would think in Praxair… Praxair's world are relatively small, compared to their total North American hardgoods. So, I wouldn't jump on that as an explanation for the differential, and there must be some other reason.

Edward Yang - Oppenheimer

Okay. And just a couple of modeling questions. Your interest expense moved down this quarter, but the debt was flat relatively from the prior quarter. What drove that? And second, your intercompany revenue eliminations been growing as a percentage. What's driving that? Is that a function of your greater bulk exposure?

Robert M. McLaughlin - Senior Vice President and Chief Financial Officer

The interest rate... the decline in interest rate is a function of a relative decline in our variable interest rate from the fourth quarter into the first quarter. So, that's the sole reason driving that. With respect in our company, yes, it is related to an increase in sales from our bulk business to our Distribution business, is the primary driver with respect to that.

Edward Yang - Oppenheimer

Thank you.

Operator

And our next question comes from Mike Harrison with First Analysis.

Michael Harrison - First Analysis

Hi, good morning.

Peter McCausland - Chairman and Chief Executive Officer

Good morning.

Michael Harrison - First Analysis

You talked a little bit about the cost issues in the ammonia business. But you also noted the there was some supply chain disruption. Can you give us some more details on what happened there, and what you're doing to remedy that situation?

Peter McCausland - Chairman and Chief Executive Officer

Yeah. Well, it's been hard to ship ammonia by rail, because of new Homeland Security regulations, and because the railroads are really, really busy right now. And they're making it more difficult. And we don't think this is going to last forever, but we've had to go to over the road trucking in some cases, and... but we've got that pretty well straightened out... don't expect to it be... have much impact going forward.

Michael Harrison - First Analysis

So, should we expect that the additional costs there to pretty much be confined to Q1, both on the supply chain side and the higher costs before they get offset by your price increase?

Peter McCausland - Chairman and Chief Executive Officer

Yes.

Michael Harrison - First Analysis

Okay. And then the other question I had was on kind of your M&A strategy broadly. Is there an increased focus on broadening your product offering through acquisitions, at the expense of acquiring independent distributors, or are you really just capitalizing on whatever opportunities come your way?

Peter McCausland - Chairman and Chief Executive Officer

Well, we like to think we're pretty discriminating. And there are a lot of opportunities that come our way that no one ever hears about, because they just go on by, we don't grab them. But no, I wouldn't draw that conclusion. I would say that our principal emphasis is on our core business and acquisitions. About 45% of the market has an $11 billion packaged gas and welding market in the United States. It's still held by independents. And we think there's lots of opportunity out there, and we have a bunch of those companies in our pipeline. So, that's going to be our primary focus. However, we've done a good job building adjacencies over the last several years, and we continue to look for processed chemical acquisitions, refrigerant acquisitions, and safe... we bought a couple of safety companies in the last 24 months. So, that will continue to be a focus of ours.

And these adjacency capabilities really strengthen our platform, we have more to offer the customer, we can remove hassles from the customer's operations, and we can cross-sell all of these product lines back and forth. So, it's that... those two things are... will be our principal focus through the fiscal year at least and probably beyond, and then we look... we're also looking overseas at a few acquisitions.

Michael Harrison - First Analysis

All right, thanks, Peter.

Peter McCausland - Chairman and Chief Executive Officer

Sure.

Operator

And next we'll go to Holden Lewis with BB&T.

Holden Lewis - BB&T Capital Markets

Thank you, good morning.

Peter McCausland - Chairman and Chief Executive Officer

Good morning.

Holden Lewis - BB&T Capital Markets

Can you just... a little bit more color in terms of how the… sort of the price pass-throughs through the ASUs and on Distribution, I guess I'm curious... if, on the Other gases side you were absorbing a lot of the cost increases, and not passing those on as quickly as... clearly you'll go into the future. Were you being more aggressive on the gas hardgoods side, so maybe those profits and that business was benefiting from the late pass-through on the Other side? And maybe that created a bit of a windfall in one quarter that maybe goes away next quarter? Any of that interplay in there, or were the gas hardgoods bit slow just because they weren't seeing the price pass-through from the ASUs?

Peter McCausland - Chairman and Chief Executive Officer

Well, first of all, let me address the hardgoods. When you get price increase from a vendor, you adjust the pricing in the computer. It's instantaneous. And that's pretty simple. The gas thing was no big deal, we had to buy through power during the month of June. It came in at about $1.3 million, or $0.01 a share higher than we expected. Instead of immediately changing the transfer price to our regional companies, because in our regional companies we have managers who have to manage their cost and their prices and their businesses, we decided that we would absorb that in gas ops and raise prices when the regional companies went to their customers for their overall price increase. So, you had that delay, and that's all it is... it's delay. And it's for the month of June and probably July, and then it will be gone, because our pricing increase will get us ahead of the curve and you've got our guidance for next quarter. So, we feel like it will be effective.

Holden Lewis - BB&T Capital Markets

Okay.

Peter McCausland - Chairman and Chief Executive Officer

And we don't think it was a complicated or ineffective way of handling it.

Holden Lewis - BB&T Capital Markets

Okay. Great, thanks guys.

Peter McCausland - Chairman and Chief Executive Officer

Sure.

Operator

And we have time for one more question. That will be a follow-up from Laurence Alexander with Jefferies & Co.

Laurence Alexander - Jefferies & Co.

Hi, Peter. Would you mind discussing what you're seeing in terms of the impacts of the current environment, both demand environment and raw materials on competitor behavior, or your relative competitive strength versus your competitors?

Peter McCausland - Chairman and Chief Executive Officer

Right. Well, we still fight for business everyday and customers, especially customers for our products are suffering because prices have moved up pretty rapidly. So, we're relying on our long-term relationships with our customers, the importance of our supply chain to our customers, and special services, and safety and other things, emergency response, special services that we provide the customers. And we hope that that will lead to an understanding of why we need these price increases. I think the whole industry has been raising prices, because they've had tremendous cost pressures on electricity, on diesel fuel, and what not. So, we're not alone out there, and... but still, we still fight for customers everyday, and it's not easy. There's plenty of competition out there, and we do the best we can, we make our pricing decisions based on our costs, and that's the way we operate. I don't know... is that responsive? There was a second part to the question that I forgot.

Laurence Alexander - Jefferies & Co.

Well, I think... I guess part of what I was just trying to touch on was, are you seeing in some regions, either due to regulatory changes, or competitors having trouble handling the raw material costs…

Peter McCausland - Chairman and Chief Executive Officer

Yes, well--.

Laurence Alexander - Jefferies & Co.

Is that making it easier for you to some extent?

Peter McCausland - Chairman and Chief Executive Officer

No, we haven't really seen that, except maybe the home medical segment, which is one-third of our medical gas sales, and they've been under all kinds of regulatory uncertainty for now, a long time. And it looks like some of the ambiguity has been lifted and hopefully things will stabilize. The prices of home care companies have come back up so that it's... the market might be saying that as well. So, that's the only area where we've had a group of customers under severe pricing pressures, or other pressures that I know of.

Laurence Alexander - Jefferies & Co.

Okay. Thank you.

Peter McCausland - Chairman and Chief Executive Officer

Sure.

Operator

And that concludes our question and answer session. Mr. Worley, I'll turn things back over to you for any additional or closing remarks.

Jay Worley - Vice President – Communications and Investor Relations

Well, again, we thank you all for joining us today, and I will be available all afternoon for follow-up questions. That concludes our call.

Operator

And that does conclude today's conference. Thank you everyone for your participation.

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Source: Airgas, Inc.F1Q09 (Qtr. End 06/30/08) Earnings Call Transcript
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